JP Morgan’s $2 billion loss on credit derivatives traded by its Chief Investment Office (CIO) has moved the debate over implementation of the Volcker Rule to the front page. Many claim that these trades are a clear example of the type of speculative, proprietary trading banned by the Volcker Rule. JP Morgan CEO Jamie Dimon insists otherwise, claiming the trades were intended as a hedge, which is clearly permitted under the Volcker Rule. Public discussion on the matter is confused, in part because many people are unclear about what defines a hedge and what defines a speculation. Who can blame the public when the premier vehicles for speculative trading are known as hedge funds?
Moreover, the current battle over financial reform and the Volcker Rule gives bankers an incentive to escalate the confusion. They want to continue their speculative trading, and that can only be done by labeling it either hedging or market making. Clarity is not their ally. When regulators, legislators and pundits advocate bright line tests for hedging, these bankers ridicule them as simpletons, accusing them of applying a dangerously unsophisticated understanding of financial markets drawn from a bygone era. These simpletons, they complain, fail to grasp the complexity of the modern world that bankers are tasked with mastering in order to serve the needs of society.
So, in order to try to make some progress and gain some insight from the JP Morgan case, let us first step back from the details of the current trades and losses, and from the debate over the Volcker Rule, and instead gain some clarity on the concept of hedging. Then we can double back and analyze the JP Morgan case in light of a sensible notion of hedging.
Two points about hedging…
#1. Theory: What is a hedge? How is hedging related to speculation?
A hedge is a trade that reduces risk. Full stop.
In many instances, a hedge is a transaction made in a competitive financial market so that risk is transferred at a fair price. The party laying off the risk must surrender some return, too. But it’s a fair trade. Putting on a hedge is a zero NPV transaction. There are no direct gains from hedging, although there can be indirect gains such as reducing the costs of financial distress.
Hedging and speculating are opposites. A hedge is a trade that reduces risk. A speculation is a trade that involves taking on risk. Typically, the speculator hopes to make an outsized gain in exchange for taking on the risk, while typically the hedger expects to surrender the market’s required return premium as a requirement for being relieved of the risk.
#2. Practice: What defines a hedge? How is it differentiated from a speculation?
A lone trader can employ willy nilly any criteria he or she likes in evaluating whether this or that trade is a hedge. But when trading is conducted inside a larger organization—like a bank or a non-financial company—where there must be accountability within the organization on the implementation of the organization’s strategy and adherence to the organization’s controls, it is essential to develop a sound empirical definition of a hedge. It is not enough for a trader to proclaim that she or he “knows” a trade is a hedge.
For example, accounting standards impose a burden of proof on a corporation that seeks to use hedge accounting for a given transaction. These include things like a requirement that the underlying assets being hedged – whether one security or a portfolio, or some other item – be clearly identified up front, and a requirement that the efficacy of the hedge be statistically demonstrated, and so on.
What constitutes sufficient evidence may vary according to circumstances and according to who is exercising control over whom. But in all events some standard must be identified or the concept is meaningless, and accountability and control within the organization is impossible. It is the ability to impose accountability and control that enables the organization to delegate authority and responsibility down to staff. Without accountability and control, the organization’s capability shrinks. Because a majority of hedges can be demonstrated to be hedges, it is therefore possible to assign employees the task of implementing a hedging strategy. Insofar as it is difficult to evidence that certain trades are in fact hedges, it is impossible for authority to be granted for those trades to be run – at least unless there is an effective and reliable form of control.
The public interest in the safety and soundness of the banking system, and the taxpayers’ interest in avoiding bailouts of failed banks, imposes a need for public accountability and control on bank investments. This may be exercised through supervisory agencies, and it may be exercised through legislative mandate. The Volcker Rule is one such mandate. For the public interest to be protected, it is essential that there be a standard of empirical proof for any claim that some set of transactions are allowed as a hedge: “show me they are a hedge.” Without a burden to provide evidence the transactions are a hedge, it is impossible for the public interest to be exercised. “Trust me” is not accountability. Insofar as it is difficult to evidence to supervisory agencies that certain trades are in fact hedges, it is impossible for the public to extend license for bankers to make those trades.
…and now to double back to the issue of JP Morgan.
To date, there is very little public information on the details of JP Morgan’s trades. Therefore, it is impossible to prove that they were not hedges. Of course, it is also the case that JP Morgan’s own insistence that they were hedges ring hollow until JP Morgan provides the necessary proof. Hopefully, the regulators and supervisors are being given more than mere assurances. Hopefully, the regulators will require more than mere assurances.
There has been a lot of discussion in the press about portfolio hedging, and whether portfolio hedging is a permissible activity under the Volcker Rule or a loophole allowing banks to evade the intent of the Volcker Rule. Properly defined, there is nothing wrong with portfolio hedging as opposed to hedging individual transactions. Indeed, the Dodd-Frank Act specifically allows hedging of aggregate positions. So why is portfolio hedging a hot topic? There are two reasons.
First, the term “portfolio hedging” is sometimes used as an excuse for poorly documented hedges. The real issue has nothing to do with whether the trade is hedging a single transaction or a portfolio. The real issue is complexity. But because it comes up more often and more sharply in larger combinations of securities and positions—i.e. in portfolios—the issue is mistakenly described as a problem of portfolio hedging.
Large portfolios inevitably are a bundle of many, many different risk factors. Layering on top of them any given transaction—the purported hedge—will alter the total risk and return of the portfolio in complicated ways. Therefore, evidencing that the given transaction is truly and certainly a hedge, to the satisfaction of a prescribed standard, becomes very, very difficult. Or, alternatively, in order to allow the purported hedge to pass muster, the standard is watered down so much that everything is a hedge. That is, there is no control.
So the real issue is not portfolio hedging. The real issue is whether or not there is any meaningful standard of accountability for what constitutes a portfolio hedge. If JP Morgan wants to call the CIO credit derivative trades a hedge in the sense of a portfolio hedge, that’s fine…, so long as JP Morgan’s claim is one that can be tested, i.e., so long as it is measured against a standard that meaningfully distinguishes true hedges and clear speculations. Otherwise, it’s just an excuse to neutralize public accountability and allow banks to do whatever they please.
Second, JP Morgan’s losing trades were a component of a dynamic portfolio strategy. The mandate of JP Morgan’s CIO involves running a complex, dynamic portfolio of investments in order to turn a profit. The positions in such a dynamic portfolio are constantly being adjusted. New investments are added, old positions are liquidated, weightings change and so on. Old positions can be liquidated by selling them, but the same result can be effected by layering on top of them a hedge. But the new trades layered on top may not actually be a hedge, but an essential element of the original dynamic strategy. Defining a hedge in the context of a larger, dynamic, speculative strategy is a more demanding task. The issue is not really one of portfolio hedging, although that’s the label it is given.
The bottom line is that in order for the public, via its regulatory agents, to sanction trades like those that lost $2 billion at JP Morgan, on the basis that these trades are a hedge, it is essential that the hedge claim be evidenced with data and against a meaningful standard that distinguishes hedges from speculations. Show me.